What the VIX Is Telling Us About Market Direction

It's rare to see a major sell-off in stocks when the VIX is at these low levels. Here's why.

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The VIX (^VIX) has now risen for four straight days, albeit from five-year lows. But the VIX has done that while the S&P 500 Index (INDEXSP:.INX) has actually ticked gradually higher, as it's up 0.5% on balance in those four days. A large portion of the VIX rise is in anticipation of the heavy economic calendar taking place this week (calendar here), with the FOMC decision tomorrow at the forefront. However, part of the rise is likely due to the fact that buyers of protection finally outnumbered the sellers of protection at these low volatility levels.

The VIX has gone from 12.5 to 13.5, but so what? Realized volatility on the SPX is still very depressed, with 10-day realized volatility at 4.5, and even 30-day realized volatility, which captures some of the December 2012 volatility, at a low 12.4.

The chart of 10-day realized volatility for the SPX over the last two years:

Courtesy of Bloomberg

With that backdrop, the VIX at 13.5 all of a sudden doesn't feel too cheap.

The VIX is a forward-looking measure, though. Market participants are well aware of the quiet over the past three weeks, yet are only concerned with positioning for future movements. When the VIX is this low, it holds special importance for the direction of the market. Why is that?

Whether you're a long-only institution, or a more nimble player, you quickly take notice when protection pricing gets this cheap. It becomes more attractive for all market participants to buy protection. They oftentimes hold on to their stock positions and buy the cheap protection, or even buy more stocks and buy protection alongside it, or simply sell their stocks and buy calls in their place. Net all these scenarios though, and you usually end up with a situation where people are buying more stocks than they otherwise would if protection was more expensive. It's a bit like driving faster because you are wearing a seat belt -- it's sunny, and the road is clear and in good shape.

As a result, it's rare to see a major sell-off in stocks when the VIX is at these low levels. Rather, we think you need to see the VIX start to tick up, and make the protection more expensive, before market players decide that they'd rather sell their stocks than buy protection against it. In other words, the conditions need to get a bit more dangerous for everyone to slow down.

It's why we are paying especially close attention to the VIX as it trades at these low levels.